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Start Investing: Why securitised credit

26 Jun 2024

What is securitised credit?

Securitised Credit is an asset class which consists of bonds or instruments that comprise cash-generating assets such as residential and commercial mortgage loans, auto loans, credit card loans, etc. These illiquid assets are purchased and restructured into various tranches through the securitisation process. 

The differences between securitised credit and bonds

Source: HSBC Asset Management, June 2022. For illustrative purpose only, with all other factors assumed to be equal.

How does it work?

A group of assets is purchased and transformed into Securitised Credit by a Special Purpose Vehicle (SPV) which is a separate company of a financial institution with its own balance sheet. It bears the obligations and liabilities of such loans and gets financing by grouping these loans into different tranches based on their characteristics such as maturity, credit ratings, etc. Senior tranches typically have higher credit ratings due to their payment priority.

Advantages of Securitised Credit

  1. Yield pick-up: Securitised Credit can offer a yield premium compared to traditional bond instruments.
  2. Floating rate exposure: Securitised Credit, which is largely a floating rate, offers a spread above a short-term reference interest rate. The yield usually follows the moves in interest rates. Whilst interest rates are anticipated to fall in 2024, they are likely to remain higher than the past decade, meaning yields on offer are still attractive.
  3. Room for price appreciation: Being a credit product, as interest rates fall, Securitised Credit spreads are likely to tighten. Furthermore, their spreads have remained artificially wide since COVID and have yet to really tighten in comparison to traditional fixed income, providing room for price appreciation.
  4. Credit enhancement: provides a cushion against collateral losses via features such as tighter covenants, overcollateralisation[@overcollateralisation], etc.
  5. Diversification benefits: it has low correlation to other bonds and can increase portfolio diversification within the bond allocation.

Types of Securitised Credit 

Key risks

  • Interest Rate Risk: As interest rates rise debt securities will fall in value. The value of debt is inversely proportional to interest rate movements.
  • Credit Risk: Issuers of debt securities may fail to meet their regular interest and/or capital repayment obligation. All credit instruments therefore have the potential for default. Higher yielding securities are more likely to default.
  • Exchange Rate Risk: Investing in assets denominated in a currency other than that of the investor’s own currency perspective exposes the value of the investment to exchange rate fluctuations.
  • Asset Backed Securities (ABS) Risk: ABS are typically constructed from pools of assets (e.g. mortgages) that individually have an option for early settlement or extension, and have potential for default. Cash flow terms of the ABS may change and significantly impact both the value and liquidity of the contract.
  • Derivative Risk: The value of derivative contracts is dependent upon the performance of an underlying asset. A small movement in the value of the underlying can cause a large movement in the value of the derivative. Unlike exchange traded derivatives, over-the-counter (OTC) derivatives have credit risk associated with the counterparty or institution facilitating the trade.
  • High Yield Risk: Higher yielding debt securities characteristically bear greater credit risk than investment grade and/or government securities.
  • Liquidity Risk: Liquidity is a measure of how easily an investment can be converted to cash without a loss of capital and/or income in the process. The value of assets may be significantly impacted by liquidity risk during adverse markets conditions.
  • Operational Risk: The main risks are related to systems and process failures. Investment processes are overseen by independent risk functions which are subject to independent audit and supervised by regulators.

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